Why the Fed taper isn’t reversing monetary policy trends
James Bullard assesses how close the FOMC is to its goals (Part 6 of 7)
Bullard weighs in on the Fed taper
While speaking at the Tennessee Bankers Association’s annual meeting in Palm Beach, Florida, on June 9, 2014, the CEO and president of the Federal Reserve Bank of St. Louis, James Bullard, said the FOMC’s getting closer to its target and is close to bringing the macro economy back to pre-crisis levels. However, what Bullard also noted was that monetary policy still remains far from its pre-crisis levels.
Monetary policy’s reaction to the 2009 credit crisis was to lower the policy rate to zero and implement outright asset purchases. Bullard said that, though the FOMC began tapering the pace of its asset purchases in January 2014, the two main policy actions haven’t reversed so far. These actions include the following.
The Fed balance sheet is still large and increasing.
The policy rate remains at the zero lower bound.
The Fed’s balance sheet
The chart above shows how the Federal Reserve’s balance sheet has remained large and growing, even after tapering initiatives were put in place since January 2014.
The Fed funds rate
At the same time, the effective Fed funds rate remains at the zero lower bound. A “zero lower bound” refers to a situation where the short-term nominal interest rate is zero, or just above zero, causing a liquidity trap and limiting the capacity that the central bank has to stimulate economic growth. A “liquidity trap” refers to the phenomenon of increased money supply failing to lower interest rates. Usually, central banks try to lower interest rates by buying bonds with newly created cash. In a liquidity trap, bonds pay little or no interest, which makes them nearly equivalent to cash.
When an economy is stuck at the zero lower bound, the central bank can only provide further stimulus through reduced real interest rates by raising inflation expectations. Inflation is one of the major causes of interest rate fluctuations in the economy. In the U.S., the Fed sets interest rates. As the Fed lowers interest rates, more people are able to borrow more money. The result is that consumers have more money to spend, causing the economy to grow and inflation to increase. The opposite holds true for rising interest rates. Certain exchange-traded funds (or ETFs), like the ProShares Investment Grade-Interest Rate Hedged ETF (IGHG), which has its major holdings in companies like Citigroup Inc. (C) and JP Morgan Chase & Co. (JPM), the Vanguard Short Term Corporate Debt ETF (VCSH), and the PowerShares Senior Loan Fund (BKLN), are designed to protect investors against the interest rate risk inflation causes.
Bullard went on to explain why monetary policy is so far from normal while the FOMC is closer to its objective. Find out more in the next part of this series.
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